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Underlying the accounting classifications of responsibility centers is the concept of controllability. The controllability principle asserts that people should only be held accountable for results that they can control.
It is often difficult to apply the controllability principle at the lowest organizational level.
A well designed system should clearly define responsibility centers in order to collect and report revenue and cost information by areas of responsibility.
Typical examples of these organizational entities are Sales organizations.
The use of Incremental Analysis in the Responsibility Center affects both fixed and variable costs.
What is a Responsibility Center? The Responsibility is the unit in the organization that has control over costs, revenues, or investment funds. Responsibility center is an entity, held accountable for an activity/function under consideration, that becomes its objective/goal Organization can be looked upon as collection of responsibility centers. Each RC consumes certain amount of resources “INPUTS” and produces certain results “OUTPUT” Best option to assess the performance of RC starts with establishing relationship among INPUT and OUTPUT and then2 applying it scrupulously www.managementvikalp.co.in
Responsibility Centers further defined It is an organization unit for which a manager is made responsible. The center’s manager and supervisor establish specific and measurable goals for the responsibility center. The goals should promote the long-term interest of the organization.3 www.managementvikalp.co.in
The basic definition of a responsibility center Lowest organizational level at which funds control functions are carried out. Generally the same as divisions in an operating component.4 www.managementvikalp.co.in
For accounting purposes, responsibility centers have four classifications: Revenue Centers Cost Centers Profit Centers Investment Centers5 www.managementvikalp.co.in
Responsibility Centers - 1. Revenue Center - Prime concern of the REVENUE CENTER – “TOPLINE” e.g. Marketing center Inputs Output (Money directly RC’s (Sales Generated spent on achieving TASK in money terms) sales i.e. Mktg. Exp.) Generate Sales • RC has no authority to decide price. • RC is charged with cost of Marketing and not with cost of goods produced • No formal relationship possible between I & O • Performance Measure for the RC can be Revenue Budgets.6 www.managementvikalp.co.in
Revenue Center A Revenue Center is responsible for selling an agreed amount of products or services. Its manager is usually responsible to maximize revenue given the selling price (or quantity) and given the budget for personnel and expenses.7 www.managementvikalp.co.in
Revenue Center - Issues Decision Rights – Promotion Mix – Performance Measures – Maximize total sales for a given promotion budget Actual sales in comparison with budgeted sales Typically used when – RC manager has thorough knowledge about market Promotion plays significant role in generating sales RC manager can establish optimal promotion mix He can set optimal quantity and appropriate rewards8 www.managementvikalp.co.in
2. Expense/Cost Centers Responsibility centers whose employees control costs, but Do not control their revenues or investment level. Examples: Production department in a manufacturing unit, a dry cleaning business Two types of costs: Engineered: those costs that can be reasonably associated with a cost center – direct labor, direct materials, telephone/electricity consumed, office supplies. Discretionary: where a direct relationship between a cost unit and expenses cannot be reasonably made; Management allocates them on a discretionary basis (e.g. depreciation expenses for machines utilized).
Cost/Expenses Center: Engineered Expenses V/s Discretionary Expenses e.g. Manufacturing a product e.g. R&D Project Can be established scientifically Can not be established Cost varies with even small scientifically fluctuations in volume Costs varies with bigger Control is easier. Control starts volume changes with planning & ends with finished task. Review of task is the only Financial Performance measure control measure for cost suffice the purpose of evaluation. control. Control is exercised during planning stage itself, by way of establishment of budget Financial as well as non financial Performance10 www.managementvikalp.co.in measure need to be
Cost Center Inputs RC’s Output (Money spent on (Physical units TASK production) Produced) Decision Rights – Input Mix – Labor, Material, Supplies Performance Measures – Minimize total cost for a fixed output Maximize output for a given “cost budget” Typically used when – RC manager can measure output & quality of output knows cost functions, optimal input mix can set optimal quantity and appropriate rewards11 www.managementvikalp.co.in
2. Expenses Center – 2.1)Engineered Exp. Center e.g. Production Department Engineered expenses are those expenses which are arrived at with reasonable reliability.e.g. Material cost , labor cost. Inputs RC’s Output (Money spent on (Physical units TASK production) Produced) • Performance Measure for the RC is std.cost: - Std Cost of doing actual activity = Std. cost of unit activity * Quantum of Actual activity • One can establish relationship between I & O , hence performance measurement is relatively easy12 www.managementvikalp.co.in
2. Expenses Center – 2.2) Discretionary Expenses Center -e.g. R&D, Advt. Dept, a Movie Project Discretionary expenses are those expenses which can not be established with perfect accuracy Inputs RC’s Output (Money spent on (Product TASK R & D) Development) • Difficult to estimate Input (hence called MANAGED costs) • Output can not be measured in monetary terms. • Difficult to establish optimal relationship between I and O • Performance Measure for the RC is Budgeted Input and Actual Input.13 www.managementvikalp.co.in
Control Characteristics of Discretionary Cost Center • Heavy Reliance on Budgets • For on going activity its bit easier than a new project • Budgeting technique used for controlling could be – • Incremental Budgeting • Zero Base Budgeting • Difficult to control short term fluctuations, as Discretionary costs usually remain unaffected in short term unlike engineered costs.14 www.managementvikalp.co.in
Discretionary Expenses Center - Examples i) Administrative and Support Centers- Senior management units at corporate level e.g. Legal, Planning , IT , Audit Departments • Goals may differ and hence performance ii) Research and Development Centers – • The input and output may span over different and uneven time periods. iii) Marketing Center -15 www.managementvikalp.co.in
3. Profit Center - Profit is most comprehensive measure of performance Function/Activity having highest influence on Bottom Line suits best for Profit Center. Can be a Business Division or any of the functional unit Demands highest freedom/autonomy than any other RCs’ Output Inputs RC’s (Money-profit (Money spent for TASK Earned out of sales) earning profits) Relationship can be established16 www.managementvikalp.co.in
Profit Center Decision Rights – Input Mix – Labor, Material, Supplies Product Mix Selling Price Performance Measures – Actual Profits Actual Profit in comparison with budgeted profits Typically used when – RC manager has knowledge about correct price/quantity RC manager has knowledge to select optimal product mix CANDIDATES FOR PROFIT CENTER ……………17 www.managementvikalp.co.in
3. Business Unit as Profit Center Business Units In a Decentralized Company Best suited as Profit Center Marketing Center as Profit Center– Marketing Function having highest influence on Bottom Line, e.g. Colgate, Coca-Cola, Wipro- Bath Soaps division, Dabur-Cosmetics division etc. When centralized control is infeasible e.g. Foreign Marketing Center e.g. IBM, Microsoft, Honda India To Convert Marketing Division into Profit Center Charge cost of production to revenue center Grant of maximum autonomy to the unit Delegate sufficient authority Treat the unit as a mini company18 www.managementvikalp.co.in
3. Functional Unit as Profit Center Manufacturing Division – When Cost of production having highest impact on Bottom Line and When Marketing Function is relatively insignificant o e.g. Nirama Detergent To convert a Production Division in to Profit Center Credit selling price less marketing expenses to production division 3. Service and Support Center – o e.g. Maintenance, Customer Service, Transportation, Engineering Design Divisions Given greater autonomy, helps them to cut cost and make its operations more efficient19 www.managementvikalp.co.in
3. Profit Center – Performance Measures Performance Measure Justification• Revenue Less VC of Mfg. & Marketing1. Contribution Margin Fixed Cost is beyond control of PC Less Fixed Expenses2. Direct Profit All Expenses incurred at the behest of PC Less Controllable Corporate Expenses Some HQ expenses exclusively incurred3. Controllable Profit for given PC at HQ – IT services Less Other Corporate Allocations Common unavoidable expenses incurred to run a company ; e.g.4. Net Profit Before taxes All administration, financing and tax planning activities are carried at HQ Less Income tax In some cases RC do have impact on tax liability of the company -5. Net Profit Tax Heavens20 www.managementvikalp.co.in
3. Profit Center - Advantages • Improves quality of decision – RC Mgr are closest to the point of decision • Improves speed of decision – less intervention by HQ • HQ is relieved of day-to-day decisions making process – can concentrate on more strategic decisions • Provides training ground for general mgt. as RC’s acts as mini Cos’. • Enhances profit consciousness with every expense made. (mktg. mgr. will tend to authorize promotional expenditure which increases the sales). • Provides best performance indicators of Co’s individual component. • Since output is clear cut evident, it evokes competition. • Ensures better and safer delegation of authority. • Ensures better motivation and evokes commitment.21 www.managementvikalp.co.in
3. Profit Center – Dis-Advantages • Caliber of RC mgr. may hamper the decision. • Incase of more integrated company there may be problems of cost sharing, transfer pricing, sharing credit for revenue. • Divisionalisation may impose additional cost of admn/support units. • Functional set up may not have competent of GM to manage RC. • Functional units once cooperated may now be in competition with one another- (as profit of one is loss to another). • May encourage short term motive at the expense of Co’s overall goal. • Optimization of RC’s profit not necessarily mean optimization of company’s profits. • Decentralization makes top mgt. to rely more on MC reports22 www.managementvikalp.co.in
Responsibility Centers 4. Investment Centers – Output Inputs (Money/net profit (Money spent for RC’s Earned on account Starting & running TASK of investment) the business) • Objective – Make sound investment decision • It compares Business units profits with assets employed to earn that profit i.e. efficiency of assets employed. • It satisfies both the goals of business organizations i.e. to earn the profit and to achieve optimal relationship in profits earned and assets employed23 www.managementvikalp.co.in
Investment Center Decision Rights – Input Mix – Labor, Material, Supplies Product Mix Selling Price Capital Investment Performance Measures – Actual ROI Actual Residual Income i.e. EVA Actual ROI & RI in comparison with budgeted ROI & RI Typically used when – RC manager has knowledge about correct price/quantity RC manager has knowledge to select optimal product mix RC manager has knowledge about investment opportunities24 www.managementvikalp.co.in
Return on Investment – Return on Investment- Relating the profits of a firm with the investment made. ROI can be computed in many different ways depending upon the need and relevance. 1. Return on Assets - ROA 2. Return on Capital Employed - ROCE 3. Return on Shareholder’s Equity - ROE25 www.managementvikalp.co.in
Return on Investment – Return on Assets Net Profit 1) Return on Assets = --------------- * 100 Assets ROI terminology would change depending on what Assets base one takes for computation; it can be - Total Assets, Fixed Assets, Gross Assets, Net Assets, Tangible Assets or Employed Assets26 www.managementvikalp.co.in
Return on Investment – Return on Capital Employed Net Profit2) Return on Capital Employed = ------------------------- * 100 Capital Employed Capital implies the long term funds supplied by creditors & owners Alternatively it can be Net Working Capital + Fixed Assets27 www.managementvikalp.co.in
Return on Investment – Return on Shareholders’ Equity Net Profit3) Return on Shareholders’ Equity = ---------------- * 100 Equity Capital Equity includes the preferential capital, however the ordinary shareholder bears the entire risk. Net Worth represents the equity capital plus the reserves and surpluses the portion solely represented by equity holders’. Net Profit- Pref. Divi.Return on Shareholders’ Equity = ------------------- * 100 Net Worth28 www.managementvikalp.co.in
Economic Value Added - EVA® (Stern & Stewart) As lender require certain interest on their money, owners too expect certain rate of return on their funds. (taken together both termed as cost of capital). Hence no "real" money is made or value is created until the operating profits exceed the rupee return required by the owner and the lenders. Increase in EVA, Increase in Market Value of the firm29 www.managementvikalp.co.in
Economic Value Added – EVA® (Stern & Stewart) • EVA is another of the way to relate profits to assets employed. • Economic Value Added = Net Profit – Capital Charge Capital Charge = Capital Employed * Cost of Capital • EVA=Net profit – (Cost of Capital * Capital Employed) • This is nothing but Residual Income which adds to the value of the firm30 www.managementvikalp.co.in
Return on Investment V/s Economic Value Added 1. ROI is a ratio. Simple 1. EVA is Profitability & easy to understand, measure in money term. Meaningful in absolute Can not be used for sense. Being a common comparison with other denominator of Business Unit or industries it can used for Industries. comparison.31 www.managementvikalp.co.in
Return on Investment V/s Economic Value Added 2. Different ROI % 2. EVA provides an provides different effective measure than incentives across BUs’ ROI. EVA Stresses upon (e.g. BU having current ROI recovery of cost of of 30 will be discouraged to capital. And welcomes go for additional investment every rupee earned over giving 25% ROI, even though and above COC. the ROI is greater than Cost of Capital OR BU mgr can improve its ROI by just disposing the assets which give lesser ROI than current one)32 www.managementvikalp.co.in
Return on Investment V/s Economic Value Added 3. ROI does not allow 3. EVA enables to use different treatment for different rates of interest different kind of assets for different types of i.e. it treats all assets involving different assets/investments at risks. e.g. low rate for par. inventory investment whereas higher rate for fixed investment.33 www.managementvikalp.co.in
Return on Investment V/s Economic Value Added 4. It is difficult to define EVA has got strong & an explicit relationship positive correlation with between ROI and market value of the firm. Market value of the firm. (ROI not necessarily indicate the market value of the firm.) (shareholders worth maximization may not be suitable measure for RC’s performance evaluation Because it is consolidated effect of entire company)34 www.managementvikalp.co.in
Return On Investment35 www.managementvikalp.co.in
Momence Associates is evaluating the performance of three divisions: Maple, Oaks, and Juniper. Using the following data, compute the return on investment and residual income for each division, compare the divisions’ performance, and comment on the factors that influenced performance. Maple Oaks Juniper Sales $100,000 $100,000 $100,000 Operating income $ 10,000 $ 10,000 $ 20,000 Assets invested $ 25,000 $ 12,500 $ 25,000 Desired ROI 40% 40% 40%36 www.managementvikalp.co.in
Solution Momence Associates is evaluating the performance of three divisions:Maple, Oaks, and Juniper. Using the following data, compute the return oninvestment and residual income for each division, compare the divisions’performance, and comment on the factors that influenced performance. Maple Oaks JuniperSales $100,000 $100,000 $100,000Operating income $ 10,000 $ 10,000 $ 20,000Assets invested $ 25,000 $ 12,500 $ 25,000Desired ROI 40% 40% 40%ROI=Operating Income/Assets InvestedMaple= $10,000/$25,000= 40%Oaks= $10,000/$12,500= 80% Residual Income=Operating Income-(Desired ROI x Assets Invested) Maple= $10,000-(40% x $25,000)= $037 www.managementvikalp.co.in Oaks= $10,000-(40% x $12,500)= $5,000
Economic Value Added38 www.managementvikalp.co.in
E 13. Leesburg, LLP, is evaluating the performance of threedivisions: Lake, Sumter, and Poe. Using the following data,compute the economic value added by each division andcomment on each division’s performance. Lake Sumter PoeSales $100,000 $100,000 $100,000After-tax operating income $ 10,000 $ 10,000 $ 20,000Total assets $ 25,000 $ 12,500 $ 25,000Current liabilities $ 5,000 $ 5,000 $ 5,000Cost of capital 15% 15% 15%39 www.managementvikalp.co.in
E 13. Solution Leesburg, LLP, is evaluating the performance of threedivisions: Lake, Sumter, and Poe. Using the following data, compute the economicvalue added by each division and comment on each division’s performance. Lake Sumter PoeSales $100,000 $100,000 $100,000After-tax operating income $ 10,000 $ 10,000 $ 20,000Total assets $ 25,000 $ 12,500 $ 25,000Current liabilities $ 5,000 $ 5,000 $ 5,000Cost of capital 15% 15% 15%EVA=After-tax operating income - Cost of capital(TA-CL)Lake: $10,000 – 15%($25,000-$5,000) = $7,000Sumter: $10,000 – 15%($12,500-$5,000) = $8,875 40 www.managementvikalp.co.in
Computing EVA for HLL Calculation of 1999 1998 1997 1996 ROCEOperation Profit 1,206 956 711 464- Less 129 101 58 55 Depreciation- Less Tax Paid 318 286 281 173- Less Tax shield 5 8 11 17 on interestNet Optg Profit less adj Taxes 754 562 361 219 (NOPLAT)Average Capital 2,118 1,703 1,412 688 EmployedWACC (%) 19 18 19 22Capital Charge 402.42 306.54 268.28 151EVA 351.58 255.46 www.managementvikalp.co.in 92.72 41 98
Incremental Analysis in the Responsibility Center Incremental analysis is used to find the impact of changes in costs or revenues, given a specific potential scenario. Decisions involving incremental analysis include the following: Make or buy (Profit Center) Sell or process further (Revenue Center) Special order (Cost Center) Changes in production and/or technology (Investment Center)42 www.managementvikalp.co.in
. Identify each of the following as a cost center, a discretionary cost center, a revenue center, a profit center, or an investment center. 1. The manager of center A is responsible for generating cash inflows and incurring costs with the goal of making money for the company. The manager has no responsibility for assets. 2. Center B produces a product that is not sold to an external party. 3. The manager of center C is responsible for the telephone order operations of a large retailer. 4. Center D designs, produces, and sells products to external parties. The manager makes both long-term and short-term decisions. 5. Center E provides human resource support for the other centers in the company.43 www.managementvikalp.co.in
Solution1. The manager of center A is responsible for generating cash inflows and incurring costs with the goal of making money for the company. The manager has no responsibility for assets. P2. Center B produces a product that is not sold to an external party. C3. The manager of center C is responsible for the telephone order operations of a large retailer. R4. Center D designs, produces, and sells products to external parties. The manager makes both long-term and short-term decisions. I5. Center E provides human resource support for the other centers in the company. DC` 44 www.managementvikalp.co.in
Identify the most appropriate type of responsibility center for each of the following organizational units. 1. A pizza store in a pizza chain 2. The ticket sales center of a major airline 3. The South American segment of a multinational company 4. A subsidiary of a business conglomerate 5. The information technology area of a company 6. A manufacturing department of a large corporation 7. An eye clinic in a community hospital 8. The food-service function at a nursing home 9. The food-preparation plant of a large restaurant chain 10. The catalog order department of a retailer45 www.managementvikalp.co.in
Solution 1. A pizza store in a pizza chain P 2. The ticket sales center of a major airline R 3. The South American segment of a multinational company I 4. A subsidiary of a business conglomerate I 5. The information technology area of a company DC 6. A manufacturing department of a large corporation C 7. An eye clinic in a community hospital P 8. The food-service function at a nursing home C 9. The food-preparation plant of a large restaurant chain C 10. The catalog order department of a retailer R www.managementvikalp.co.in46
A simple summary of the responsibility centers Output measured in Revenue Center monetary terms Expense/Cost Centers Input measured in monetary terms Profit Centers Output measured in monetary terms Investment Centers Output measured in monetary terms47 www.managementvikalp.co.in